Question: How much did my investment portfolio make last year? When I look on my tax return, the numbers just don’t seem to add up to what my adviser is telling me. Please help.
Answer: Tax season does seem to be a time investors try to solve the mystery of investment performance. However, if you are looking to your tax return for the solution, you will likely get it all wrong.
Your tax return only measures a few things. You only report to the IRS the dividends and interest you received and the gains and losses on investments you sold last year. Remember, this reporting is just for your taxable accounts. As you mentioned, the sum total of these two categories on your return is often not even close to what your entire portfolio actually earned last year. Understanding the difference isn’t easy, but it is worth the effort.
Since the investments you sold last year may have been purchased many years ago, the tax information of "sales proceeds minus your original cost" has nothing to do with how much money you made between two dates, such as Jan. 1 to Dec. 31. When you ask how much money you made last year, those two very specific dates are your total focus. Unlike you, the IRS doesn’t share your focus on those two arbitrary dates.
Additionally, since your taxable dividends and interest only concern investments you held in your taxable accounts, your tax return completely ignores the income you may have earned in your tax-deferred accounts — such as your IRA or your 401(k). In many cases, a significant segment of an investor’s holdings reside in tax-deferred accounts. Unlike you, the IRS doesn’t get to look at these accounts.
Figuring your portfolio’s true return for the year is an entirely different task. It basically requires you to be a cross between Steven Spielberg and Ansel Adams. Calculating your return asks you to take a snapshot of your portfolio at the start of the year — then film a short movie of the investment actions you took during the year — and then finally take a fresh snapshot of your portfolio at the end of the year.
With this information in hand, there are five parts to add up. These are (1) the dividends and interest you received plus (2) the change in the value of the investments that you started with and held for the entire year, plus (3) the change in the value of the investments that you bought during the year and held until the end of the year, plus (4) the change in the value of the investments that you started with and decided to sell during the year, plus (5) the change in the value of the investments you bought during the year but decided to sell before the end of the year.
How much did your portfolio make last year? It is a simple question with a complex answer...that you most certainly cannot find on your tax return. Save yourself the effort, ask your adviser.
Jason P. Tank is a chartered financial analyst and co-owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. He encourages questions and comments about future columns. Contact him at 947-3775, by email at Jason@FrontStreet.com or at www.FrontStreet.com